Replacement Bait: Why the 80% Rule is Wrong

The Retirement/Investment Complex calls it your "retirement income replacement rate." It's the percentage of your pre-retirement income you "need" to sustain your standard of living in retirement.

We call it "replacement bait." The percentage is set so high that it requires us to save an excessively large portion of our income. This endows the financial services industry with fees and commissions on our savings for decades before our savings will do anything for us. We need to remember that our retirement savings are their lunch.

They say we should target a retirement spending level that is roughly 80 percent of our pre-retirement income. One regularly cited source of the replacement-rate figure is AON Corp., a major consulting company. It conducts, with Georgia State University, periodic replacement-rate studies.

The 2008 study is just out. For incomes of $50,000, it suggests a replacement rate of 81 percent. It suggests a low of 77 percent for incomes of $70,000 to $80,000, and a whopping 84 percent for $150,000.

Unfortunately, it has no connection to life as most of us know it. It ignores, for instance, the fact that most of us spend a good deal of our income on raising and educating children. It also ignores the fact that most of us spend much of our adult life paying off a home mortgage.

This is income we don't need to replace when we retire.

As we discuss in "Spend 'Til the End" (Simon & Schuster, $26), the recommended replacement rate targets from the financial services industry are far too high. You can see why by considering the life of two 30-year-old newlyweds, Sandy and Daryl Graves.

They live in Delaware, earn a combined $75,000, and plan on having two children in the next four years. Sandy and her employer each contribute 3 percent of her $50,000 salary to a 401(k). Sandy and Daryl just bought a $300,000 house with a 20 percent down payment -- a gift from Sandy's folks. Monthly mortgage payments are $1,439. Annual property taxes, homeowner's insurance and maintenance total $6,500.

They plan to send their kids to moderately priced colleges. They also plan to retire at 65 and hope to earn a real return, after inflation, of 3 percent. If they get a higher return, they'll be pleasantly surprised. They also plan to live to 100 because (1) they might, and (2) planning to live so long gives them a margin for error. If they die at 100, the only asset left will be their house. If they die before then, the kids will get the house and some financial assets.

Sounds pretty normal, right?

So if they set a goal of having a level standard of living throughout their lives, do you think they'll be able to spend $60,000 (80 percent of $75,000) in today's dollars, starting at 65?

No way, especially once you realize that this $60,000 is just the target for discretionary spending and housing expenses.

Because they wouldn't be able to borrow enough to completely smooth out their spending, they'll have only $29,785 a year to spend on themselves in their 30s and 40s. It will rise to $35,352 a year once they turn 57. They will also have $6,500 a year to spend on their home operating expenses throughout their lifetime.

So the right target for discretionary spending and housing expenses is $41,852 -- miles below $60,000. This 56 percent replacement rate is what's needed to maintain Daryl and Sandy's living standard and cover their housing costs right through age 100. Add future taxes and an adjustment for Medicare premiums (which aren't considered in typical replacement rate estimates), and the target replacement rate hovers just over 60 percent. That'sstill miles below the frequently cited 80 percent.

The reason they can't live like kings in retirement is simple. They have kids to rear, a mortgage to pay off and tuition to cover. Saving every penny they make today simply isn't an option.

That's real life.

Mention future Medicare premiums and other old-age health expenses, and the financial services industry will provide you with even higher targets for retirement spending and current saving.

In fact, rapidly rising Medicare premiums will have a major impact on the standard of living the couple (and everyone else) will be able to sustain in retirement. We'll show you just how large that impact may be next week.

Full disclosure: Our figures come from ESPlanner, a financial planning program based on life-cycle finance and consumption smoothing that is marketed by my co-author's company at http://www.esplanner.com

Why you don't need to replace 80% of your pre-retirement income.

All amounts are in today’s dollars. For many households, adult consumption cannot be completely smoothed to a level, lifelong figure due to borrowing constraints on the household. Basically, you can’t borrow enough when young. When this happens the consumption smoothing program solves for the smoothest possible path.

Expense

Age 35

Age 45

Age 55

Age 65

Age 75

Age 85

Age 95

Adult Consumption (1)

$29,795

$29,795

$29,795

$35,352

$35,352

$35,352

$35,352

Cost of Children (2)

$12,903

$12,903

$12,903

$0

$0

$0

$0

Home Operating Expense(3)

$6500

$6500

$6500

$6500

$6500

$6500

$6500

Mortgage (4)

$14,462

$10,761

$8,007

$0

$0

$0

$0

Education (5)

$0

$0

$15,000

$0

$0

$0

$0

Total Non Retirement Spending (2+4+5)

$27,365 (36.5%)

$23,664 (31.6%)

$35,910 (47.9%)

$0

$0

$0

$0

Income Taxes (6)

$5,797

$6,592

$11,252

$2,580

$2,404

$2,178

$1,902

FICA Taxes or Medicare B Premiums (7)

$5,737

$5,737

$5,737

$2,311

$2,311

$2,311

$2,311

Total Retirement Spending (1+3+7+6)(Percent Salary)

NA

NA

NA

$46,743 (62.3%)

$46,567 (62.1%)

$46,341 (61.8%)

$46,065 (61.4%)

Regular Saving Plus Retirement Acct. Contributions

$2,490

$5,487

($69)

($980)

($2,355)

($2,881)

($3,520)

Source: ESPlanner Case Study, Kotlikoff & Burns

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